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Welcome to Rule #1

Phil Town

Rule #1 Is about

investing. Good

investing is about

certainty.Andy Bargerstock

Webinar #2 Main Points

• Homework on MOS calculations

• Rule One Long Term Investing

• Payback Time

• Cap Rate Valuation

Companies Being Researched

Student search for Wonderful Companies:UTHR (2) - United Therapeutics

AGX (2) - Argan

THRM (2) – Gentherm

FRAN (2) – Francesca’s Holdings

GILD - Gilead Sciences

IPGP - IPG Photonics

USG – USG Corp

FB – Facebook

SNX – Synnex

MASI – Masimo Corp

Finding Wonderful Companies

1) Meaning (industries you understand)

2) Use a good Rule #1 Score (75-100)

3) Use the Rule #1 Gurus who invest like us (focused investments in a few companies and low turnover)

4) Look for events that are driving fear into a company or industry (watch the headlines)

Research to reach “Certainty”

• Read the “Business” section of the SEC Form 10K

• Go to the corporate website and find, “Investors Relations”

-- Read CEO Letter to the Shareholders in Annual Reports

-- Listen to the last Quarterly Earnings Call webcast

• Look for relevant articles and interviews in trade journals and industry web sites through Google search

• Research the CEO with Google search and youtube.com

• Read articles in seekingalpha.com and gurufocus.com for background on the company and industry

Long Term Mindset

• Our long term mindset is dictated by the concept of “certainty.”

• One of our best allies is time itself.

• We have time for Mr. Market to correct himself – going from a rational price to a fearful price back to a rational price and even beyond to greed.

Payback Time Calculation

PBT Requires Free Cash Flow/Share

• Payback Time (PBT) concept: if we bought the whole company (all the profits are ours) – how many years does it take us to get “paid back” based on the stock price we paid?

• We want to get paid back in eight years or less since the market is normally willing to wait about sixteen years.

• Since this valuation system is based on us getting paid back from profits, we want to use the highest quality of profits.

• Earnings Per Share (EPS) is an accounting number for tax purposes. It is not really the cash management has to work with to grow the company. Free Cash Flow (FCF) is more accurate indicator of value creation.

• The eight year PBT price is arrived at by using “Free Cash Flow Per Share” in replace of “EPS(TTM)” in the MOS Calculator.

Finding FCF: 3 paths

• We look for Free Cash Flow (FCF) in three places.

1. MOS Calculator – the FCF work is done for you.

2. Cash Flow Statement – check the MOS Calculator number by looking for negative numbers in the Net Income and Cash From Operating Activities – use the FCF Excel Spreadsheet if necessary to recalculate.

3. FCF TTM at www.gurufocus.com (15 yr. Financials)

• After checking all three versions of FCF/Share, we use the one (or blend) that seems most reasonable based on what we know about the company.

Path #1: FCF from calculator

Path #2: Excel Averaging

• Use the spreadsheet you received at the Transformational Investing Workshop (TIW).

• Average the last 4-5 years of Net Income, Cash From Operating Activities and Purchase of Property and Equipment.

• If you discover a more conservative FCF per share number, you can overwrite the FCF/share in the calculator and submit.

Path #3: TTM Gurufocus.com

Finding FCF/sh on calculator

PBT Price on Calculator

Cap Rate - Valuation System #3

• Cap Rate stands for Capitalization Rate and is a method of valuing an investment – usually used in real estate.

• We think of businesses like many people think of a real estate investment – a money making machine based on the net profit it generates.

Cap Rate of 10

• One way to look at a business is by analyzing the amount of cash it is generating after certain expenses. If you can keep a good profit after expenses and expect it to continue in the future, you have a good deal.

• In real estate, when an investment will return a Cap Rate of 10, it is considered a good deal – especially if it is a good property that can be improved.

• Most investors would be happy with a return on their total investment of 5% on a good property or company.

• If we can get a return of 10% after most expenses, on a great company, we are getting the company on sale.

Calculating Cap Rate

• Our calculation of a company’s Cap Rate starts in the CASH FLOW STATEMENT.

• We need to calculate “Owners Earnings”

1) Add the top three numbers in the

Cash Flow Statement

2) Subtract the Maintenance Cap Ex from the total

3) The result is the “Owner’s Earnings”

4) Multiply the Owner’s Earnings by 10

5) The result is how much you could pay for the company and receive a 10% return on your investment

Maintenance Cap Ex

• The “Maintenance Cap Ex” number is the money the company spent to replace worn out property and equipment for the last fiscal year.

• It can sometimes be found in 10K financial notes

• Broken out by management in an Earnings Call

• Google search: (company) maintenance capex

• In Seeking Alpha articles on the company

• Guessing based on how much you can find they spent on growth projects (new stores, etc.)

• Gurufocus.com has a Maintenance Capex number

Maintenance Cap Ex - Guru Focus –Stock Symbol in Search - Definitions

Owner’s Earnings Calculation

FROM THE CASH FLOW STATEMENT

Net Income+ Depreciation, amortization+/- Deferred Income Taxes- Purchase of Property, Equipment or Cap Ex – just the Maintenance Cap Ex (with Growth Cap Ex taken out -if you can determine what it is)-------------------

= Owner’s Earnings

Cash Flow Statement – Add Top Three Items

_______$61,130

Purchase of Property, Equipment (also known as Capital Expenditures or Cap Ex)

Refinement of Purch. Of Prop., Equip.

• Purchase of Property and Equipment (or Cap Ex) is an expenditure that we need to refine if we can.

• This expenditure is made up of purchases of prop. and equip. that was for maintenance and for growth.

• The accountants do not differentiate between these two but we want to if we can.

• We want to subtract only Purchase of Property and Equipment that was for maintenance (also known as “Maintenance Capital Expenditure.”)

• Maintenance Cap Ex is NOT a number that you can find on a line of the financial statements. It has to be guess-timated.

Finding Maintenance Cap Ex

• Sometimes, management states the growth or maintenance number in the earnings calls.

• It is sometimes referred to in the 10K Business Section or in the accounting footnotes of the 10K.

• If you cannot find something that helps you determine how much was spent on growth or maintenance – take a guess at how much the company spent on Prop and Equip (Cap Ex) on growth and subtract that from the number in the Cash Flow statement.

• If guessing is not possible, then be conservative and use the whole number for Purchase of Property and Equipment.

gurufocus – 15 yr Finanicals – click Owners Earnings

Owner Earnings Definition – 5y Avg of Maint Cap Ex

This is just a suggestion. Maintenance Cap Ex is a rough idea. Check the Earnings Calls and 10K formore help and look to recent years to see if the number found here is useful.

Owner Earnings Calculation

AAPL - FROM THE CASH FLOW STATEMENT

$45,687 B Net Income

$10,505 B Depreciation and Amortization

$ 4,938 B Deferred Income Taxes

--------------

$61,130 B

- 8,961 B Maintenance Purchase Prop. & Equip.

--------------

$52,169B Owner Earnings / by 5,332 shares = $9.78

$9.78 x 10 (Cap Rate required) = $97.84

How to buy 100 sh. on TOS

Let’s visit TOS to discover how to buy 100 shares on paper money…. An important skill for next homework.

Resources to Use for Research

• The company’s web site – Investor Relations

• www.yahoo.com - Finance

• www.seekingalpha.com

• www.gurufocus.com

• www.tdameritrade.com

• www.youtube.com

• www.insidermonkey.com

• www.insidercow.com

• google: trade journals

Rule #1 Investing is not rocket science!

• You can be successful

• Read and then read some more

• Challenge the assumptions and think long term

• History trumps projections (if they differ)

• Buy fear when you find value

• Sell excitement and greed

• Perfection – not required

• Patience – mandatory

• Discipline and self-confidence – pays off

• Sell Rule One Puts (ROP) – win-win

Homework

Dig deeper into your prospective Rule #1 Wonderful Company or switch to a new prospective company.

Start a journal and keep notes on each company.

Write the notes in terms of the Four Ms (Meaning; Moat; Management; MOS – sticker/MOS/PBT).

With each subsequent class we want to move closer to application. Theory is nice but practice makes perfect.

Paper trading allows us to make mistakes but learn as we go.

• Action: Buy 100 shares of a company you have been researching on ThinkOrSwim (TOS) PAPER MONEY.

• Note the details of the transaction in your journal.

andyb@ruleoneinvesting.com